Swedroe: Beware The Recency Pitfall

"Recency" can be described as the tendency to overweight recent events or trends and ignore the long-term evidence. It’s one of the more common and costly behavioral mistakes that individual investors can make, often leading them to buy high and sell low. Clearly, this represents a major problem, as such behavior is exactly opposite of the formula for investing success. My colleague, Kevin Grogan, director of investment analysis at The BAM Alliance, provided me some of his thoughts on how to look at this issue.

A Perilous Pitfall

To start, according to Grogan, many investors place too much emphasis on recent, short-term performance when making investment decisions. The financial media tends to exacerbate the problem, rather than helping investors stick to a disciplined strategy. When evaluating your asset allocation and deciding which fund to use, recent performance should not be a significant factor in your choice. Good strategies will have bad years (or maybe even many bad years in a row).

A current example of this focus on short-term performance involves investors questioning whether or not it still makes sense to own a globally diversified equity portfolio. The argument goes along these lines: The U.S. has outperformed international markets by a wide margin for the last five years, and even if you go back as long as 10 years, U.S. markets are still way ahead of international markets.

The chart below displays the trailing performance of the S&P 500 and the MSCI All Country World ex USA Index (an index that combines both developed non-U.S. markets and emerging markets) through Sept. 30, 2015.

The trouble is that stock returns are extremely noisy from a statistical perspective, so even a period as long as 10 years isn’t extensive enough to make a definitive statement that U.S. equities will outperform international equities going forward. To illustrate this, we’ll take a look at some additional data points.

The chart below reports the trailing performance of the same two indexes we considered before, except that the returns are through Dec. 31, 2009. An investor standing in January 2010 and using past performance to make decisions likely would’ve abandoned their U.S. allocation and shifted into international stocks, right before the U.S. wound up outperforming.

Beware High Valuations

In addition, many investors fail to consider that recent outperformance often leads to higher valuations. Higher valuations lead to lower expected returns in the future, and vice versa. The S&P 500 currently has a Shiller CAPE 10 yield of 4.4% and a dividend yield of 2.1%. The MSCI EAFE currently has a Shiller CAPE 10 yield of 6.5% and a dividend yield of 3.2%.

To calculate the expected return using the dividend yield, we can add 2 percentage points to the dividend yield (as an estimate of real growth). This gives a 4.1% real expected return on the S&P 500 and a 5.2% expected return on the MSCI EAFE.

To calculate the expected return using the Shiller CAPE 10 yield, we need to make an adjustment to the raw number to reflect the annual growth in earnings (roughly 1.5% per year). To do this, we multiply the raw number by 1.075 (1.5 x 5 years, the average time lag). This gives us a real expected return on the S&P 500 of 4.7% and 7.0% on the MSCI EAFE.

Either method for calculating expected returns indicates that international markets have lower valuations than U.S. markets. The data is even more compelling for emerging markets, where valuations are even lower. It is particularly difficult to avoid the temptation of chasing the past performance of emerging markets, given how volatile they are.

In short, chasing past performance can cause investors to buy asset classes after periods of strong recent performance, when valuations are relatively higher and expected returns are lower. It can also cause investors to sell asset classes after periods of weak recent performance, when valuations are relatively lower and expected returns are higher.

Effectively, investors who chase recent performance are systematically buying high and selling low. A better approach is to follow a disciplined rebalancing strategy that systematically sells what has performed relatively well recently and buys what has performed relatively poor recently.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.